Euroweek offshore RMB report: a dollar alternative?

Euroweek, July 2011

It’s not too hard to envisage a future when the RMB is a reserve currency to rival the dollar. It can’t happen now, of course: no currency that is not freely convertible could serve such a purpose, and while China’s current account is opening, its capital account remains very much closed. But if you assume the end-game is full convertibility, then it’s perfectly logical to see the RMB as another world currency.

“China now holds 30% of the world’s US$9 trillion foreign reserves,” says Woon Khien Chia at RBS. “The other 70% which does not belong to the People’s Republic of China could potentially be held in CNY. As China’s share of world trade matches that of the US, the demand created for CNY to settle exports and imports could potentially be as big as that for US dollars.”

As the RMB becomes more international, it’s also natural to wonder if it can become an alternative to the dollar in terms of debt capital markets fund-raising.

To an extent, one could argue it already is. Certainly the growth of the domestic RMB capital markets has been a game-changer for Chinese issuers. “China has become a significant financing market with a domestic bond market that didn’t kick off until the last few years and has quickly become the third-largest in the world,” says Eric Greenberg, managing director, financing group at Goldman Sachs. Another banker adds: “It’s an infant. It will become the largest market in the world once it’s grown into a toddler.” When the RMB becomes a more open and convertible currency, why shouldn’t that domestic market serve the same international purpose as the dollar capital markets do today?

For the moment, the swift growth of offshore RMB bond markets also demonstrates that the Chinese currency has become a useful funding source. One sees development of this market both for domestic and international issuers. “Real estate has obviously been a very significant component of overall issuance, and will continue to be because there is obviously significant demand for housing in a huge economy with a very large population,” says Rod Sykes at HSBC, speaking of Chinese debt market issuance generally. “But I do think we will see an increasing proportion of issuers not from that segment of the market. They may be industrials, manufacturers, retailers. In the RMB market, for instance, we’ve seen renewable energy and retail recently.”

And while the domestic issuer base has grown, RMB is already proving useful for a growing number of internationals, among them McDonald’s, Caterpillar, and lower-rated names like Galaxy Casinos and Russian bank VTB. Clearly, the volumes raised by issuers like these are limited so far, and in McDonald’s case predicated upon the need to have RMB available for expansion onshore. “Issuers that fund at 50bp or 60bp over Libor in the dollar market are not looking at CNH bonds as a source of arbitrage funding,” says Herman van den Wall Bake, head of global risk syndicate at Deutsche Bank. “They may pay around 130bp more, after the swap, than they would from a straight dollar bond. But if you have a real need for renminbi, it is lot cheaper to sell CNH bonds than it is to fund onshore.”In any event, it’s a start, and international issuance is only going to grow.

That growth will start with a steady maturing of the market, already underway. “We need to see a deepening of the offshore RMB market,” says Puay Yeong Goh, FX strategist at Credit Suisse. “We need the People’s Bank of China to continue allowing more CNH bonds so as to build a benchmark curve for the market.” As discussed in other chapters, the rate of growth of RMB deposits in Hong Kong makes for a ready market to digest these issues.

As that market deepens, there is likely to be an increased willingness for further FX liberalization. “The next step in the gradual opening of the capital account would probably be for the PBOC to start allowing offshore banks to put their money back into China, allowing the QFII status to be used for RMB rather than just converting foreign currencies into RMB,” Goh says. “That’s a gradual step, further down the road. The timeline is pretty difficult to call, but it’s going to be the medium term: two to three years.”

The true use of the RMB as an international currency on a dollar standard also requires a number of the idiosyncracies of the existing arrangement to unwind. These are the consequences of the limited opening of the currency with a closed capital account, which means – as explained elsewhere in this guide – that the same currency behaves in completely different ways onshore and offshore, and operates on three different forex curves. “As CNH deposits increase and liquidity improves, you should start to see a convergence of the NDF [non-deliverable forward] towards the [deliverable] CNH curve,” Goh says. “Right now the problem is that CNH liquidity is about one third of NDF liquidity, so there’s not enough force to push the market to converge. When liquidity in both curves is similar, you should see convergence; but the gap can continue to widen because of the controls in place. Until you see more opening of the capital account, it’s difficult to see convergence.”

While some bankers are loving the opportunities provided by this clear arbitrage, others are wary. “CNH doesn’t exist except in our heads,” says one very senior western banker, a country head in Asia. “We are all for helping China do what I think it means to do, which is to make the RMB an international currency of trade and settlement. But the arbitrage… I’m saying to our wealth management people, be very careful, because if all this unwinds, you’ve got nowhere to turn.”

On the trade settlement side, RMB is becoming more international by the day. The volume of international trade settlement conducted in RMB was RMB310 billion in the first quarter of 2011, according to the HKMA, which is close to the full year total for 2010, itself a vast increase in 2009. “There is a lot of room to grow,” says Goh. “For the next one to two years at least, this pace of growth should not slow down.” That growth – and not just in Hong Kong – is essential for greater application of RMB as a reserve or international capital markets currency. “It will eventually go to a reserve currency, but there are a lot of hurdles,” says Goh. “For it to be on a par with the dollar or even the euro, there needs to be much broader and deeper usage of the RMB beyond the central banks. It needs to be an international currency for trade settlement and financing,” which in turn means a fully open capital account, he says.

Still, the momentum is clearly in that direction. There is, for example, a lot of talk about including the RMB as a currency within the basket of special drawing rights (SDRs) run by the International Monetary Fund. French finance minister Christine Lagarde was vocal about this idea in the annual Davos meeting in January. “It is quite bizarre that the Chinese currency is not part of the basket underlining the SDR, because China is the second largest economic power of the world, and first for exports of goods and services,” she said then, in remarks that are particularly relevant since Lagarde is now quite likely to be the next head of the IMF itself. Since SDRs are, by definition, international foreign exchange reserve assets, inclusion in the basket would be a significant step towards internationalization.

So if we forward the clock, say, five years, and see a fully convertible RMB, what does that mean for capital markets? Well, it becomes an option to consider like any other currency: something to be weighed up along with interest rates of the time, calls on likely currency direction, the available maturities for fund-raising, and investor sentiment. Just as issuers weigh up the pros and cons of an issue in dollars, euros, sterling or yen today, in the near future they will simply add the RMB to the mix.